By Brendan Brown
Can Trump-economics prevent the asset price inflation now infecting the global economy - with its origins in the radical monetary experiment under the Obama Administration - from moving on to its late deadly phase?
Two Options: "Economic Miracle" or "More of the Same"
According to many popular narratives in the market-lace since Election Day, the implicit answer is yes. Either an economic miracle (i.e., a period of renewed economic growth) or a dose of old-style monetary stimulus will do the trick, we are told.
Neither of these reprieves would likely be permanent. But, as the advocate told K in Kafka's "The Trial," full acquittal is not an option; the best outcome to be hoped for is indefinite postponement, the second best is provisional postponement.
An economic miracle would achieve the best outcome - at least until the Fed again inserted a monkey wrench into the machinery of the economy (as Alan Greenspan did in the late 1990s); further inflationary monetary easing could bring about the second best option (though this will make the final bust even worse in the end).
Judging by the market's response to the election, it appears the idea of a reprieve (and an economic miracle) continues to be popular among those hoping for a "soft landing." Fewer seem to be placing their trust in more monetary inflation (at least if we're judging by the weakness of gold and the strength of the dollar found in the market right now).
Yet some caution is advisable, and just because the markets hope for an economic miracle doesn't mean one will happen.
The "Miracle" Option: Can We Repeat the Volcker Boom?
The tales of change in Washington sparking a miracle are unconvincing unless they feature prominently the US on a journey to sound money. A partial historical analogy is the attack on high inflation initiated by Carter's appointment of Volcker to the Fed in 1978 and continued under the first Reagan Administration. This culminated in a spell of prosperity, but crucially only after a severe recession first.
Today's road to sound money would be different in many respects as the starting point is not high goods and services inflation, but feverish asset price inflation both in the US and globally (In the late 1970s, asset price inflation was evident in lending to the "less developed countries"). Moreover, the new administration today is not inheriting a Federal Reserve which is already reversing its previous wild policies. Prominent architects of the radical monetary experiment are still in power right now.
There are some market actors apparently still placing their hope in the idea that president-elect Trump will follow up his anti-Fed rhetoric during the campaign with early action. This would include key new appointments to the Federal Reserve Board and doing a deal with the Democrats in the Senate such that a monetary reform bill could make its way through a potential filibuster to his desk. But there are many uncertainties here.
Support for Fed's reform is certainly not a given from Republicans still favoring the Taylor Rule. Moreover, who knows whether Trump would respond to economic adversity along the road to sound money by echoing Richard Nixon's notorious statement that "we are all Keynesians now."
Indeed, those who hope for a miracle include many Keynesians who think an expansion of fiscal policy (i.e., mass new infrastructure programs) can be mixed with tax cuts to move the economy forward. The skeptics, of course, question this, and are pointing to the likely problems of crony capitalism and poor productivity, plus the crowding out of more worthwhile opportunities. Tax cuts are not sustainable or credible if there is no agenda to meaningfully shrink big government.
Also, there would be every reason for citizens to fear higher taxes including the hidden inflation tax in the future as payback for enlarged deficits now.
The Inflation Option: Can We Repeat the Richard Nixon-Arthur Burns Experience?
On the other hand, some think that more inflationary policy from the Fed may put the bust off yet again. Some market actors predict a rise in monetary inflation - explained by the Fed resisting upward pressure on market rates. But those who see continued inflation maintain that this would be supportive of real asset prices and economic growth. The higher natural rate - in so far as it reflected increased economic dynamism (investment opportunity, entrepreneurship) would be consistent with overall good news. But we will likely have to concede the good news would turn to bad in the face of increasing infrastructure spending or more general government spending.
It may be helpful to recall that Fed Chairman Arthur Burns instituted his own inflationary monetary experiment from 1970 to 1973, even as the economy appeared to have already peaked in the late '60s. As a result, the Nixon Administration in effect delayed the Day of Reckoning for the Kennedy/Johnson asset price inflation of 1962-1967 by creating a short-lived inflationary boom of its own. That may be a parallel for the Trump team (including the Federal Reserve) to consider. The 1962-1967 asset price inflation, however, occurred alongside a global economic miracle (including Continental Europe and Japan) which continued into the next few years. The asset price inflation of the last few years has occurred without any economic miracle to be seen. And a key element in this present day asset price inflation has been the giant carry trades into long-maturity government debt and into corporate bonds (both investment grade and high yield).
Any story about Trump-economics should include an exposition of how and when that carry trade unwinds. The bust would most likely bring on the end-stage of the Obama asset price inflation including most likely the much-talked-about eventual China crash. The best hope is that after all the fêting of fantasy miracles, a real miracle announces itself based most likely on a simultaneous blossoming of technology and entrepreneurship (analogous to the IT boom of the mid-1990s or the mass assembly line and electrification boom of the mid-1920s) and without the long slog of a painful monetary reform and related recession first.
Disclosure: No positions